December 2015

Improving project value through effective cost management

  • By Dr Brett King, CEO, COMET Strategy Pty Ltd

The importance of developing appropriate frameworks to ensure project success

Managing costs is critical to the operation of any major company, particularly operating mining businesses. This article outlines a structured approach for making major cost decisions to improve project value, determining which items should be kept and those that should be eliminated. While revenues can be difficult to control due to the underlying geology of the deposit or the market determined price, costs are normally within the control of a business. Costs can be kept at previous levels, scaled back, eliminated or increased with high levels of control. 

The flexibility to reduce costs has often been used strategically to improve the profitability and its value to shareholders. Regrettably, there are many examples of revenue reduction as a consequence of across-the-board cost reduction. The net impact is substantially reduced project profitability and a destruction of shareholder value. What is needed is a framework to determine which costs are excessive and should be reduced and which costs are not and should be maintained or even increased.

A framework for managing costs should be designed to maximise value to shareholders. To be effective, this framework needs to incorporate both clear technical and relevant people issues into a practical, repeatable and generic system.

Identifying a single overarching objective

The first step is to clarify a single overarching objective that can be used for the project, incorporating all key elements. While this seems to be a simple step, projects often use multiple objectives or ‘proxies’ for shareholder value. These proxies need to be checked to see if they do in fact add shareholder value for each scenario being evaluated.

On first inspection it may seem that total cost could be used to compare different scenarios where lower costs are better. While cost reduction programs have the ultimate goal of improving shareholder value, they might be undertaken using the simple goal of minimising costs. There are often costs that can be identified that are no longer needed and do not impact downstream processes, which  can be eliminated to simply improve profit and the value of the project. Cost minimisation implemented without consideration of downstream implications on the business can result in losing more value than the costs saved, thereby destroying shareholder value.

Before we can evaluate if a cost should be reduced (or increased), we need overarching criteria to measure its value to the shareholders. Before defining the best measure of shareholder value, let’s take a moment to consider why there needs to be only one overarching objective, rather than many.

Companies often have multiple goals displayed prominently for employees to read and give their best efforts to achieve or exceed. These may include reducing injuries and unsafe practices, achieving an annual production target, increasing the mineral reserves, being an employer of choice, keeping costs less than industry targets and so on. While these are often well aligned with each other, they can also conflict with each other. For example, when determining the scope and scale of an exploration drilling program, keeping costs down can conflict with increasing mineral reserves. Which measure should be used?

With many objectives, employees may need to undertake analysis for each of these objectives, resulting in undertaking similar work many times with the associated increased time for making the decision. Once all the work is completed for each objective, there is the problem of which one to use. Ultimately only one choice can be made for each decision and normally each objective produces a different result. How do you ensure that the best option for the company is chosen? By choosing the overarching measure of shareholder value – one that appropriately balances revenues (eg from all the metals or products), costs (eg exploration, mining, processing, marketing, sales), productivities (eg truck and shovel utilisation and efficiency, metal recoveries) and all project constraints (including mining fleet, processing, infrastructure, safety and environmental).

Net present value (NPV) is widely used in the mining industry and is normally the best proxy for shareholder value (Brealey et al, 2010). While there are some limitations, it is a far superior overarching measure of shareholder value than individual department objectives, and all other financial measures (including Payback Period and Internal Rate of Return). The NPV allows a fair weighting between different departmental costs and capital injections, and also recognises the monetary value of time over the life of the project. This inherent balancing of costs, revenues, and current and future values has also led to NPV being used by stock market analysts to estimate the share price position of listed companies from all industries, not just mining.

While the impact on NPV is sometimes difficult to measure, it remains the standard instrument that major capital decisions are best measured with. This article assumes that NPV is the best measure of shareholder value. The projects being considered are large, typically over 10 years, and need to determine the best capital cost management strategy over the life of the project.

The NPV needs to be maximised over the entire life of the project using realistic periods. While the casual user often assumes both of these criteria, some algorithms have a ‘distorted NPV’ calculation that biases the final choice of the best decision. 

For example, in scheduling a 30 year project, if the algorithm only considers five annual periods at a time during the optimisation, then revenue and costs outside of this period are not considered, and there would be reduced incentive to strip a phase that does not have its ore mined in the five years, thus biasing related decisions. Compensating by creating artificial minimum stripping ‘constraints’ creates a partly manual schedule and no longer guarantees the best NPV for the project. Better decisions are made when algorithms maximise the full NPV over the whole project life (Lane, 1964, 2014).

Prioritised alternatives

Prioritised activity should not be a surprise for those familiar with maximising the value of a system. This article prioritises capital costs over operating costs and other productivity decisions. While analysis should be prioritised according to the overarching objective, when starting this process the objective may not have been established and a rule of thumb or expert judgement may be initially used. A simple rule of thumb for determining which capital costs to start with might be to analyse the largest capital expenditure items first.

While many operating cost reduction programs reduce costs by tens to hundreds of thousands of dollars, capital cost decisions regularly involve many millions or even billions of dollars. Although both types of decisions can be worth implementing, shareholders want to prioritise the decisions that are likely to make the greatest impact on the value of the project.

For capital costs, a list of possible capital reduction and expansion options will normally be evaluated. This often includes both the size and timing of fleet expansion and processing capacity options, each with associated capital, operating cost and productivity implications. Brainstorming with a group of expert and senior leadership staff is often useful for identifying a range of alternatives and their possible impact on project value. This can be used for the analysis of first-order prioritisation.

Prioritising tasks are only beneficial if action is then taken. If managing large capital decisions is identified as the most important priority in the current environment, it must be followed by appropriate analysis and action on this priority.

Measurement and quality optimisation

Now that we are acting on our prioritised alternatives we will need to measure the impact of the various options using our objective. Capital expenditure often has many implications on the mining and processing schedule and so a new schedule is normally needed to determine the new NPV. This is often not obvious to financial analysts who are not familiar with the mining process, as illustrated in the following example.

Consider the scenario where the cost of various mining fleet capital is higher than previously expected (lower prices can produce the same effect). The tendency is to simply use the same schedule and fleet requirements and change the capital cost when the new equipment is purchased. If the costs are significantly higher, some of the mining stages will not be profitable and the analysts may simply ‘lop off’ periods at the end of the schedule that are not profitable. The resulting schedule used may still include some unnecessary stripping and will probably use cut-off grades that are no longer appropriate for the shorter life project.

A better solution can often be found by optimising the schedule with the new costs being considered. In a revised and optimised schedule that considers these new capital costs, the stripping for phases that are not mined is completely removed and cut-off grades for each period are recalculated to maximise project NPV. The result is often higher value schedules with a more realistic valuation of the scenario, leading to better decisions.

Analysis and feedback

Now that we have high-quality measurements of the value of the various capital investment alternatives, we need to undertake some analysis to determine the best path forward.

Much of this analysis is very straight forward if you can simply look at the range of NPV measurements for the various options, and pick the scenario with the highest value. Some caution should be exercised at this point to ensure that those undertaking the analysis are appropriately trained. For example, we may have considered a range of expansion options for the mining fleets (trucks, shovels and associated ancillary equipment). We may have also considered a range of processing capacity expansions with their associated impacts on costs, recovery and productivity. An experienced strategic planning engineer would ensure that some cases of increased mining capacity are undertaken with increased processing capacity.

One of the great advantages of the analysis stage is learning about where the significant value drivers are for the project. Often there are very few people who have access to information on the value of the entire project so there are many new areas for improving the project value discovered during this stage. The importance of learning the value drivers can be further leveraged by ensuring that site staff undertake the analysis. Site staff that ‘live and breathe’ the project are often better placed to respond to changing conditions and possess greater knowledge of what can be changed to help improve the project value.

Analysis and feedback is best undertaken by a multidisciplinary group of people. For example, a change in the production schedule would be provided to mining operations, processing, logistics, marketing, finance and management for feedback. While all cases cannot be provided to all people, the more important cases should receive greater review to pick up mistakes, gain greater team ownership and uncover more ideas on ways to further improve project value.

Some periodic independent and expert feedback into the analysis is considered best practice given the magnitude of the decisions and the prevailing levels of experience in this field in the industry. The independent feedback would ideally have experience in the optimisation techniques discussed in this article across a broad range of projects.

The analysis will typically result in some additional scenarios to evaluate or the fine-tuning of decisions. This feedback should flow back into the new prioritised alternatives, better measurements and sometimes even into the objectives to make sure it truly reflects shareholder value.

Case study

A case study has been provided to help see how this Cost Management Optimisation can be implemented. This case study illustrates an area where large capital expenditure is often incurred: the mining fleets.

The largest capital items in the mining side of the operation are normally the truck and shovel fleets. Additional trucks and shovels are often required to expand the fleet capability or to replace old equipment. The planned size of the mining equipment fleets is often determined in the feasibility study for the project based on the geology, mining, processing, environmental and market costs, productivities and prices. Many of these factors change over time and so the appropriate size of fleets needs to be reviewed periodically, typically annually.

For example, consider the size of the truck fleet. The number of trucks is normally matched to the number of shovels; the cycle times to the various waste dumps and crushers.

Firstly, consider the implications on the truck fleet of a simplistic goal of reducing annual costs by ten per cent. The cost reduction will normally also carry an associated goal of maintaining the budgeted metal production so as not to lose revenue. To reduce the annual cost of the operation, projects can often reduce the number of trucks operated, perhaps park ten per cent of the trucks and/or not buy additional trucks. In order to not sacrifice the metal production while using fewer trucks, plans can be adjusted so that the areas containing ore continue to receive high priority, but the waste handling receives a lower priority. In this way, metal production targets are still achieved and the operating costs of the business are reduced. The truck fleet requirements could be substantially reduced in this scenario. The waste that is no longer mined may not impact on the business for several years until eventually the reduced availability of high value ore is impacted. In this scenario the impact on shareholder value can be substantially worse than the costs saved, while the high capital processing assets and business infrastructure are not utilised with high revenue generating ore. We clearly need a much more sophisticated measure of shareholder value than the cash flow for a few years.

The implications on the value of the project for large capital decisions last many years or even decades. This framework will use the full value implications on the entire business (NPV, the single overarching objective), not just during the budgeting period. Analysis of the project for scenarios with and without the extra trucks, finding a profitable case for a good decision, requires multiple cases to determine the size and timing of the truck fleet.

The impact on revenue and costs also need to be evaluated according to the year in which the value is realised. Although costs saved this year are more valuable than the same revenue lost next year, substantial revenue forfeited in the future can outweigh short-term cost savings.

This systematic analysis leads to many measures of potential project value that will then reveal if cost reduction goals should be applied to the truck fleet and how large the cost reduction should be.

If the delayed or reduced revenue is less than the value saved through cost reduction, should this decision be implemented? There may be times when significantly more than 10 per cent of costs should be saved, and other times when costs should actually be increased so that maximum project value is achieved.

Pre-stripping is a clear example of when we need to incur upfront costs to gain revenue in future years. Large multiphase projects require many stripping initiatives, and each needs to be implemented to maximise shareholder value. These large projects require the cash flows from every period to be optimised simultaneously so as to maximise the value of the project and associated shareholder value.

Conclusion

Costs are a vital component of project value and, unlike the revenue and discount rate, we have substantial control over them. To reduce costs without destroying shareholder value, we need to model the impact of these cost reductions against changes to the value of the project. The crucial starting place of the cost management optimisation is the identification of the overarching
objective that aligns the analysis with shareholder value; normally project NPV. By defining the criteria to be measured for each case we greatly increase the efficiency of analysis and the value delivered to shareholders. 

Optimisation also has a crucial role in making sure decisions are in the best interest of the company. Care must be exercised to make sure full NPV calculations are used in the optimisation and that simultaneous policy optimisation is undertaken for decisions.

Acknowledgements

This article summarises experiences from working with many exceptional mining engineers who have patiently helped discover and learn from these practical challenges. 

A version of this paper was presented at the Orebody Modelling and Strategic Mine Planning SMP 2014 Symposium.

References

Richard A Brealey, Stewart C Myers, Franklin Allem, 2010. Principles of Corporate Finance. 10th Edition. McGraw-Hill.

Lane K F, 1964. Choosing the optimum cut-off grade, Q. Col. Sch. Mines Vol. 59, No. 4, pp811-829

Lane K F,  2014. The Economic Definition of Ore: Cut-Off grades in Theory and Practice. 4th Edition, www.cometstrategy.com, Australia.

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